Don't end up owing taxes on money you've just invested

Mutual funds

November 03, 1996|By NEWSDAY

A reminder: It is getting near the end of the year, a time when mutual fund investors who want to buy new funds have to look at the consequences of income and capital gains distributions from the funds they are considering.

Failing to do so can mean paying taxes on money you just invested and getting fewer shares for the same amount of money.

Mutual funds are required by law to distribute dividend income and net realized capital gains to their shareholders every year, which is usually done in December.

The amount of the distribution is deducted from the net asset value -- the share price -- of the fund. And the distribution is taxable income unless the shares are held in a tax-deferred account such as a 401(k) pension plan or an individual retirement account.

These distributions could be a problem for some fund shareholders this year because many of the hot new funds are aggressive-growth funds that often invest in initial public offerings, which tend to jump in value if the managers have guessed right. Some of these stocks get sold, generating gains that are distributed to fund shareholders.

Of course, some initial public offerings and stock picks are losers, and if the managers do their job well, they can offset positive capital gains with negative ones.

That leaves little to be distributed and the net asset value showing positive gains with no tax consequences.

The June-July technology crash, for example, created enough losers for some funds to offset the capital gains winners.

In addition, new managers taking over an old fund have a tendency to sell off stocks that do not fit their investment style, and that also generates capital gains and distributions. Even if you reinvest the dividends and capital gains, you'll still owe taxes on them.

(Capital gains distributions should not be confused with the capital gains tax you may have to pay if you hold fund shares for more than a year and sell them for a profit.)

Take a real example: You buy $5,000 worth of Vanguard/Trustees International, which was selling for $32.39 a share the other day, and get about 154.4 shares. But when Vanguard declares its distribution of $5.21 a share, two things happen. The net asset value drops to $27.18 and you get $803 from Vanguard, which will be paid Jan. 2 but is taxable in 1996.

But that $803 is really part of the $5,000 you just paid, so you are getting your own money back. The problem is that it is taxable, and if you are in the 30 percent bracket, you'll owe about $240. So you now have 154.4 shares worth $4,197 and $603 cash, for a total of $4,760.

Even if you used the $603 after-tax money to buy 22 more shares at the lower $27.18 price, your 175 shares would be worth only $5,668 if the price went back up to $32.39.

But if you buy after the distribution, when the net asset value has dropped to $27.18, your $5,000 buys you 184 shares and you don't have to worry about distributions until next year. If the share price goes back up to $32.39, you will have shares worth $5,959.

So before you buy anything now, it pays to call the mutual fund company and find out when it is declaring a distribution for the fund you are interested in and how much it will be.

There may be no distribution this year, or it may be so minimal as not to matter. Then do the numbers. It is only simple division and multiplication. And while it may seem like a lot of numbers, with a long-term investment that is rising, those extra shares are money in your pocket.

If you are already a shareholder and are dollar-cost averaging your purchases every month, don't worry about the distribution or its tax consequences. All this means is that you will be buying some shares cheaper one month, which is the point of dollar-cost averaging.

There are also some tax considerations, said Alan Weiner, a partner in Holtz Rubinstein, a Melville, N.Y., accounting firm.

For example, if you own $50,000 worth of shares in a mutual fund with a 15 percent distribution, you have an additional $7,500 in income to account for.

Weiner said you may need to determine whether you have to pay additional quarterly state and federal income taxes, or whether the quarterly payments you have already made protect you from any penalties.

In addition, he suggests, a large gain can be offset by selling some stocks or funds that have had losses.

Bull market caution

While you may be optimistic about buying stocks, there are some signs that the booming bull markets of the '80s and '90s have raised investor expectations too high.

Historically, the average return on stocks has been about 10.7 percent a year.

A new survey called the Investor Reality Check found that more than half the investors asked believe that stocks will match the 14 percent annual return of the last decade, while an amazing 29 percent said they think stocks will do better than that.

Only 14 percent believe that stocks will do worse.

Liberty Financial's chief investment strategist, Porter J. Morgan, cautioned that investors "could be in for a serious disappointment if they expect the market to keep rising."

They don't expect much of a market decline, either. Forty-one percent said the market will not suffer a drop of more than 10 percent in total return in any one year over the next decade.

If they are wrong, and the market drops about 25 percent, investors said they would consider selling their stock funds.

But 84 percent said they would hold on to their funds or buy more shares if their funds dropped 20 percent. The buy-and-hold and buy-on-the-dip philosophies seem to have bitten deeply.

Liberty Financial, which manages $45 billion in assets, including 60 funds from Colonial, Stein Roe Farnham and Newport Pacific, paid for the survey, conducted by Lou Harris Associates.

Pub Date: 11/03/96

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